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The liquidity effect in the federal funds market: evidence from daily open market operations

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  • Seth B. Carpenter
  • Selva Demiralp

Abstract

We use forecast errors made by the Federal Reserve while preparing open market operations to identify a liquidity effect at a daily frequency in the federal funds market. Unlike Hamilton (1997), we find a liquidity effect on many days of the reserve maintenance period besides settlement day. The effect is non-linear; large changes in supply have a measurable effect, but small changes do not. In addition, a higher aggregate level of reserve balances in the banking system is associated with a smaller liquidity effect during the maintenance period but a larger liquidity effect on the last days of the period.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2004-61.

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Date of creation: 2004
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Handle: RePEc:fip:fedgfe:2004-61
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Keywords: Federal funds market (United States) ; Federal funds rate ; Liquidity (Economics);

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  1. Lawrence J. Christiano, 1991. "Modeling the liquidity effect of a money shock," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 3-34.
  2. Jordi Galí, 1992. "How Well Does The IS-LM Model Fit Postwar U. S. Data?," The Quarterly Journal of Economics, Oxford University Press, vol. 107(2), pages 709-738.
  3. Seth Carpenter & Selva Demiralp, 2008. "The Liquidity Effect in the Federal Funds Market: Evidence at the Monthly Frequency," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(1), pages 1-24, 02.
  4. Nelson, Daniel B, 1991. "Conditional Heteroskedasticity in Asset Returns: A New Approach," Econometrica, Econometric Society, vol. 59(2), pages 347-70, March.
  5. Eric M. Leeper & David B. Gordon, 1991. "In search of the liquidity effect," International Finance Discussion Papers 403, Board of Governors of the Federal Reserve System (U.S.).
  6. James D. Hamilton, 1996. "Measuring the liquidity effect," Working Papers in Applied Economic Theory 96-06, Federal Reserve Bank of San Francisco.
  7. Selva Demiralp & Dennis Farley, 2003. "Declining required reserves, funds rate volatility, and open market operations," Finance and Economics Discussion Series 2003-27, Board of Governors of the Federal Reserve System (U.S.).
  8. Ben S. Bernanke & Ilian Mihov, 1998. "Measuring Monetary Policy," The Quarterly Journal of Economics, Oxford University Press, vol. 113(3), pages 869-902.
  9. Hamilton, James D, 1996. "The Daily Market for Federal Funds," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 26-56, February.
  10. Adrian R. Pagan & John C. Robertson, 1995. "Resolving the liquidity effect," Review, Federal Reserve Bank of St. Louis, issue May, pages 33-54.
  11. Daniel L. Thornton, 2001. "Identifying the liquidity effect at the daily frequency," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 59-82.
  12. Cochrane, John H, 1989. "The Return of the Liquidity Effect: A Study of the Short-run Relation between Money Growth and Interest Rates," Journal of Business & Economic Statistics, American Statistical Association, vol. 7(1), pages 75-83, January.
  13. James A. Clouse & Douglas W. Elmendorf, 1997. "Declining required reserves and the volatility of the federal funds rate," Finance and Economics Discussion Series 1997-30, Board of Governors of the Federal Reserve System (U.S.).
  14. Bernanke, Ben S. & Mihov, Ilian, 1998. "The liquidity effect and long-run neutrality," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 49(1), pages 149-194, December.
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